Retirement Accounts vs. Retirement Plans: How do they differ? On the surface, individual retirement accounts and qualified retirement plans are both trying to help you get to the same place, retirement security. While both retirement accounts and retirement plans are there to help you plan for the future, these two vehicles run remarkably differently. Retirement accounts are not the same as retirement plans, as they differ in tax treatment, investment options, and possible employer contributions. So how does a person choose?
While it is possible to contribute to both, you can’t do it with the same dollars. It’s important to understand your retirement savings options and consider their long-term implications. Think about your money in three groups: what you make, what you grow, and what you distribute. Saving money is vital to a happy retirement, and you want to make sure your retirement strategy will give you the results you desire. Here are the major differences between retirement accounts vs. retirement plans.
Retirement Accounts vs. Retirement Plans: They Are NOT The Same
Individual Retirement Accounts
An Individual Retirement Account (IRA) is a tax-favored retirement account that lets you contribute a certain amount each year and invest your contributions tax-deferred. An IRA is an investment account. Once you’ve contributed your money to the account, you can invest in stocks, bonds, mutual funds, and other types of investments. You can even buy and sell investments within the IRA. You pay no taxes on annual investment gains with IRAs, which help them to grow more quickly.
The key advantage to IRA-based plans is that they’re easy to set up and maintain. There are a few types of IRA-based plans including SEP and SIMPLE IRA Plan.
With a regular IRA, you pay income taxes on the money when it’s withdrawn at retirement. If you try to cash out entirely before retirement, known as an early distribution, you will likely pay a penalty fee and may be subject to federal, state, and local income taxes.
While all IRA plans share some similarities, there are also a few key differences. With a Savings Incentive Match for Employees IRA, or SIMPLE IRA, contributions are made from pre-tax paycheck withdrawals, and the money grows tax-deferred until retirement.
If you’re self-employed, you can take advantage of a SEP IRA. This retirement account will allow you to contribute a portion of your income to your own retirement account, and fully deduct them from your income taxes. The maximum annual contribution limits are higher than most other tax-favored retirement accounts.
Each of these IRA accounts has varying maximum annual contributions that are allowed. It’s important to take into account your future goals when choosing which account type will be the best fit.
Roth IRA contributions are made after taxes, but then any money generated within the Roth is never taxed again. You can also take withdrawals before retirement age without penalties. Roth accounts make the most sense for individuals who believe that they will be in a higher income tax bracket when they retire than they are in currently. Why? Because it’s better to pay taxes on a smaller percentage of your income prior to contributing than to pay a larger percentage of taxes on withdrawals.
Qualified Retirement Plans
A qualified retirement plan is an employer-sponsored plan that uses a “qualified plan trust” to hold employee accounts. Qualified plans are generally governed by the Employee Retirement Income Security Act of 1974 (ERISA), and come with greater protections for employees.
The most common type of retirement plan is the 401(k). Named after section 401(k) of the Internal Revenue Code, this retirement option is a workplace retirement account, offered as an employee benefit. In order to contribute to a 401(k) retirement plan, the employee designates a portion of each paycheck to defer into the plan. These contributions occur before income taxes are deducted from the paycheck.
One of the benefits of contributing pre-tax money is it lowers the amount of income your taxes are based on. For example, if you earn $85,000 and contribute $10,000, you’re taxed on just $75,000. Many employers will match employee contributions, which means if you are not contributing up to the company match, you may be ignoring a significant employee benefit. Additionally, in a 401(k), investment gains grow tax-deferred until retirement.
Investment gains realized within the plan are not taxed by the IRS. You don’t pay tax until you actually withdraw funds from the account. At that time.you’ll add those withdrawals to your other income and pay tax on the total at whatever rates are in effect at that time. Though, similarly to a traditional IRA, if you withdraw funds from the plan before age 59 1/2, you could pay a penalty and be subject to federal, and maybe even state and local income taxes.
Variations of the standard 401(k) include the 403(b), a similar account offered to educators and nonprofit workers; and a 457(b) plan, offered to government employees.
Many people find that as they progress throughout their career, they accumulate a variety of retirement plans. The key throughout the process is to find someone who can help you realize your own unique vision of retirement. Financial Gravity is here to help you make the most of what you have. Tax planning and wealth management go hand in hand. Contact us today to Bust the 10 Tax Myths Sabotaging Your Small Business Success!